Analysis of Contingent LiabilitiesPhilip Morris

Much of the litigation against Philip Morris is related to exposure of persons to environmental tobacco smoke. This is addressed by Philip Morris in the following excerpts from its Year 8 annual report:

Pending claims related to tobacco products generally fall within three categories: (i) smoking and health cases alleging personal injury brought on behalf of individual plaintiffs, (ii) smoking and health cases alleging personal injury and purporting to be brought on behalf of a class of individual plaintiffs, and (iii) health care cost recovery cases brought by governmental and nongovernmental plaintiffs seeking reimbursement for health care expenditures allegedly caused by cigarette smoking. Governmental plaintiffs have included local, state, and certain foreign governmental entities. Non-governmental plaintiffs in these cases include union health and welfare trust funds, Blue Cross/Blue Shield groups, HMO's, hospitals, Native American tribes, taxpayers, and others. Damages claimed in some of the smoking and health class actions and health care cost recovery cases range into the billions of dollars. Plaintiffs' theories of recovery and the defenses raised in those cases are discussed below.

In recent years, there has been a substantial increase in the number of smoking and health cases being filed. As of December 31, Year 8, there were approximately 510 smoking and health cases filed and served on behalf of individual plaintiffs in the United States against PM Inc. and, in some cases, the Company, compared with approximately 375 such cases on December 31, Year 7, and 185 such cases on December 31, Year 6. Many of these cases are pending in Florida, West Virginia and New York. Fifteen of the individual cases involve allegations of various personal injuries allegedly related to exposure to environmental tobacco smoke ("ETS").

In addition, as of December 31, Year 8, there were approximately 60 smoking and health putative class actions pending in the United States against PM Inc. and, in some cases, the Company (including eight that involve allegations of various personal injuries related to exposure to ETS), compared with approximately 50 such cases on December 31, Year 7, and 20 such cases on December 31, Year 6. Most of these actions purport to constitute state wide class actions and were filed after May Year 6 when the Fifth Circuit Court of Appeals, in the Castano case, reversed a federal district court's certification of a purported nationwide class action on behalf of persons who were allegedly "addicted" to tobacco products.

During Year 7 and Year 8, PM Inc. and certain other United States tobacco product manufacturers entered into agreements settling the asserted and unasserted health care cost recovery and other claims of all 50 states and several commonwealths and territories of the United States. The settlements are in the process of being approved by the courts, and some of the settlements are being challenged by various third parties. As of December 31, Year 8, there were approximately 95 health care cost recovery actions pending in the United States (excluding the cases covered by the settlements), compared with approximately 105 healthcare cost recovery cases pending on December 31, Year 7, and 25 such cases on December 31,Year 6.

There are also a number of tobacco-related actions pending outside the United States against PMI and its affiliates and subsidiaries including, as of December 31, Year 8, approximately 27 smoking and health cases initiated by one or more individuals (Argentina(20), Brazil (1), Canada (1), Italy (1), Japan (1), Scotland (1) and Turkey (2)), and six smoking and health class actions (Brazil (2), Canada (3) and Nigeria (1)). In addition, health care cost recovery actions have been brought in Israel, the Republic of the Marshall Islands and British Columbia, Canada, and, in the United States, by the Republics of Bolivia, Guatemala, Panama and Nicaragua.

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Pending and upcoming trials: As of January 22, Year 9, trials against PM Inc. and, in one case, the

Company, were underway in the Engle smoking and health class action in Florida (discussed below)

and in individual smoking and health cases in California and Tennessee. Additional cases are

scheduled for trial during Year 9, including three health care cost recovery actions brought by unions

in Ohio (February), Washington (September) and New York (September), and two smoking and

health class actions in Illinois (August) and Alabama (August). Also, twelve individual smoking and

health cases against PM Inc. and, in some cases, the Company, are currently scheduled for trial

during Year 9. Trial dates, however, are subject to change.

Verdicts in individual cases: During the past three years, juries have returned verdicts for

defendants in three individual smoking and health cases and in one individual ETS smoking and

health case. In June Year 8, a Florida appeals court reversed a $750,000 jury verdict awarded in

August Year 6 against another United States cigarette manufacturer. Plaintiff is seeking an appeal of

this ruling to the Florida Supreme Court. Also in June Year 8, a Florida jury awarded the estate of a

deceased smoker in a smoking and health case against another United States cigarette manufacturer

$500,000 in compensatory damages, $52,000 for medical expenses and $450,000 in punitive

damages. A Florida appeals court has ruled that this case was tried in the wrong venue and,

accordingly, defendants are seeking to set aside the verdict and retry the case in the correct venue.

In Brazil, a court in Year 7 awarded plaintiffs in a smoking and health case the Brazilian currency

equivalent of $81,000, attorneys' fees and a monthly annuity of 35 years equal to two-thirds of the

deceased smoker's last monthly salary. Neither the Company nor its affiliates were parties to that

action.

Litigation settlements: In November Year 8, PM Inc. and certain other United States tobacco

product manufacturers entered into a Master Settlement Agreement (the "MSA") with46 states, the

District of Columbia, the Commonwealth of Puerto Rico, Guam, the United States Virgin Islands,

American Samoa and the Northern Marianas to settle asserted and unasserted health care cost

recovery and other claims. PM Inc. and certain other United States tobacco product manufacturers

had previously settled similar claims brought by Mississippi, Florida, Texas and Minnesota (together

with the MSA, the "State Settlement Agreements") and an ETS smoking and health class action

brought on behalf of airline attendants. The State Settlement Agreements and certain ancillary

agreements are filed as exhibits to various of the Company's reports filed with the Securities and

Exchange Commission, and such agreements and the ETS settlement are discussed in detail therein.

PM Inc. recorded pre-tax charges of $3,081 million and $1,457 million during Year 8 and Year 7,

respectively, to accrue for its share of all fixed and determinable portions of its obligations under the

tobacco settlements, as well as $300 million during Year 8 for its unconditional obligation under an

agreement in principle to contribute to a tobacco growers trust fund, discussed below. As of

December 31, Year 8, PM Inc. had accrued costs of its obligations under the settlements and to

tobacco growers aggregating $1,359 million, payable principally before the end of the year Year 10.

The settlement agreements require that the domestic tobacco industry make substantial annual

payments in the following amounts (excluding future annual payments contemplated by the

agreement in principle with tobacco growers discussed below), subject to adjustment for several

factors, including inflation, market share and industry volume:

Year 9, $4.2 billion (of which $2.7 billion related to the MSA and has already been paid by the

industry); Year 10, $9.2 billion; Year 11, $9.9 billion; Year 12, $11.3 billion; Year 14 through Year 17,

$8.4 billion; and thereafter, $9.4 billion. In addition, the domestic tobacco industry is required to pay

settling plaintiff 's attorneys' fees, subject to an annual cap of $500 million, as well as additional

amounts as follows: Year 9, $450 million; Year 10, $416 million; and Year 11 through Year 12, $250

million. These payment obligations are the several and not joint obligations of each settling

defendant. PM Inc.'s portion of the future adjusted payments and legal fees, which is not currently

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estimable, will be based on its share of domestic cigarette shipments in the year preceding that in

which the payment is made. PM Inc.'s shipment share in Year 8 was approximately 50%.

The State Settlement Agreements also include provisions relating to advertising and marketing

restrictions, public disclosure of certain industry documents, limitations on challenges to tobacco

control and underage use laws and other provisions. As of January 22, Year 9, the MSA had been

approved by courts in 41 states and in the District of Columbia, Puerto Rico, Guam, the United States

Virgin Islands, American Samoa and Northern Marianas. If a jurisdiction does not obtain final judicial

approval of the MSA by December 31, Year 11, the agreement will be terminated with respect to

such jurisdiction.

As part of the MSA, the settling defendants committed to work cooperatively with the tobacco

grower community to address concerns about the potential adverse economic impact of the MSA on

that community. To that end, in January Year 9, the four major domestic tobacco product

manufacturers, including PM Inc., agreed in principle to participate in the establishment of a $5.15

billion trust fund to be administered by the tobacco growing states. It is currently contemplated that

the trust will be funded by industry participants over twelve years, beginning in Year 9. PM Inc. has

agreed to pay $300 million into the trust in Year 9, which amount has been charged to Year 8

operating income. Subsequent annual industry payments are to be adjusted for several factors,

including inflation and United States cigarette consumption, and are to be allocated based on each

manufacturer's market share.

The Company believes that the State Settlement Agreements may materially adversely affect the

business, volume, results of operations, cash flows or financial position of PM Inc. and the Company

in future years. The degree of the adverse impact will depend, among other things, on the rates of

decline in United States cigarette sales in the premium and discount segments, PM Inc.'s shares of

the domestic premium and discount cigarette segments, and the effect of any resulting cost

advantage of manufacturers not subject to the MSA and the other State Settlement Agreements. As

of January 22, Year 9, manufacturers representing almost all domestic shipments in Year 8 had

agreed to become subject to the terms of the MSA.

Required:

a. Philip Morris classifies pending tobacco lawsuits against the company into three general

categories. What are these three categories? What is the number of claims for each of these

categories at the end of Year 8?

b. Can you determine how much liability is recorded for each of these categories as of December

31, Year 8? Explain.

c. Can you determine what amount is charged against earnings in Year 8 for contingent tobacco

litigation losses? Explain.

d. Do you believe the eventual losses will exceed the losses currently recorded on the balance

sheet? Explain.

e. Describe adjustments to PM's financial statements, and to an investor's financial analysis of PM,

to reflect estimates of under- or overaccrued losses.